Never dive for yield

Quick PointsIn this low-rate environment, everyone is in the hunt for yield.When looking for yield, take the time to ask the key questions.It is important to remember that excess yields often have excess risks.

The interest rates we’ve experienced during our lives have declined, and the yield on bank deposits and certificates of deposit has fallen to almost zero. As investment income becomes scarcer, we face the temptation to reach or, more precisely, dive for yield. This is a quest with deep risks.

Why is yield so scarce?And why is the income on our investments falling? The answers can be found in the combination of ever-lower inflation worldwide — led by oil, but driven by other factors — and the global glut of money also looking for a place to park. The chase for yield includes a lot of savvy competition.

According to my dictionary, the term yield is derived from the Old English word geldan, meaning “to pay or repay.” The Middle English word yielden took on the sense of “to produce” as in growing crops or trees.

But the financial markets in 2015 look at yield and growth as two different concepts. An ideal combination would combine both concepts — a bit of yield, a bit of growth.

How much yield is good?And how much should investors expect? The answers are not simple, but it matters that investors ask the right questions. One of the biggest mistakes is to confuse yield and distribution. A company can distribute money and within that payment is a return of capital, which is not the same as either yield or growth but is merely a give-back.

The idea of yield is quite distinct in bonds and stocksIn the world of fixed income, there is current yield, which is merely the current payment stream, with the opportunity for principal growth limited by the price of the bond. This metric is not as precise as yield to maturity, which tells the investor how much to expect the bond to deliver annually until it expires or matures. Even better is yield to call, or the yield the investor could get until the bond gets called away by the issuer. When buying bonds, it pays to ask what kind of yield we are really getting.

Equities often offer some yield as well as the chance for growth of principal. For stocks the concept of yield is not contractual, as it is for bonds. Dividend yield is not the result of an agreement or a promise, but rather comes from taking a quarterly dividend payment, multiplying it by four and dividing by the current price of the stock. Clearly the dividend payment could go up or down, as could the stock’s price; either would affect the dividend yield.

Yield rules of thumbWith everyone seemingly in the hunt for yield, it is critical to ask the right questions. After all, excess yields often have excess risks. Here is a quick checklist to follow when looking for yield in today’s marketplace:

Is the yield composed of true earnings, or is it derived from some return of capital? The biggest yield trap is going for yield that comprises not just earnings, but a return of capital.

What are the chances of missing payments — that is, credit risk — or the risk of principal losses? It’s important to recognize that some of the highest-yielding instruments are delivering high yield for a reason: The investor is faced with too much risk of not getting the original investment back. The risk of default — or the higher chance of principal reductions or missing coupon payments — is driving the higher yield.

Is the quoted yield dependent on unrealistic assumptions? A high-yielding stock may look attractive, but only because the market has already determined that it is a poor bet and the chances of more bad news are great.

What is the chance that cash flows will continue to keep the income stream alive and growing? In the case of stocks or stock-like instruments, we look for the solid ability to generate earnings and pay the dividend. Creditworthiness and demonstrable cash flow growth are virtues in the quest for yield.

It’s worth our while as investors to be on the alert for tricks that might be masking the return of capital — or measures like current yield, which disguises the true yield on a fixed income investment. Be curious and ask questions to make sure we understand where the yield is coming from and that it’s backed by steady cash flows. And always be skeptical of excess yield.

Past performance is no guarantee of future results.

No investment strategy, including asset allocation or diversification, can guarantee a profit or protect against a loss. No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

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